Trading on The Inside Edge

By THOMAS McCARROLL

After Philip Schein, the CEO of U.S. Bioscience, told Wall Street analysts last November that regulatory approval for the firm's new cancer-therapy drug was imminent, there was a stampede to buy the company's stock. By Jan. 7, Bioscience's share price hit an all-time high of 85, before a 2-for-1 split at mid-month. But on Jan. 31 came a shocker: a Food and Drug Administration panel decided not to recommend approval of the new drug, known as Ethyol.

That sent the stock into a free fall. It plunged 46% at the next session and never recovered. The shares are now trading at around 11. But not all of Bioscience's shareholders got pummeled. Schein and five vice presidents managed to bail out just in time. In the period before the FDA's bombshell, they unloaded 1.2 million shares at prices ranging from 38 to 77 1/2.

Mere coincidence? Good luck? Or, as corporate insiders who occupied decision-making positions and called the shots, did they know something that other investors didn't? The Bioscience executives refuse to say. But in a class action, a group of angry shareholders accuse the officers of cashing in on private information. The investors charge that the Bioscience insiders knew Ethyol would be rejected by the FDA as too untested, and that they deliberately misled the public about the prospects for the drug in order to sell their stock at inflated prices.

The Bioscience case represents the latest form of alleged insider trading that is troubling Wall Street. Instead of stock tipsters and takeover artists, though, the new cases involve high-ranking executives whose jobs give them access to privileged information about their business. And unlike the scandals of the 1980s -- or the charges brought last week by the Securities and Exchange Commission against investors Martin Revson and Edward Downe Jr. and others accused of making at least $13 million on inside information -- most of the trades by corporate officers are technically legal and carried out with the full knowledge of the SEC. But a recent spate of dubious transactions by corporate higher-ups has investors crying foul. Says Morris Levy, a Long Island, N.Y., securities attorney: "Shareholders are being blindsided by corporate insiders because the SEC is turning a blind eye and letting them run wild with impunity."

Like outside investors, corporate insiders are barred by securities laws from trading on information, such as earnings results and product announcements, before it is publicly released. To guard against abuses, top officers are subject to special regulation. They must, for example, report each of their trades to the SEC by the 10th of the following month. And they are subject to stiff fines and penalties for late filings.

Still, improper trades by corporate insiders are hard to police. Poor record keeping and lax enforcement by the SEC, for example, have typically made such cases difficult to detect and prosecute. Unless there is unshakable evidence to the contrary, insiders can easily explain away questionable deals as simply being fortuitous. And often even the most flagrant-appearing trades can fall within legal bounds. The Bioscience transactions, now challenged by shareholders as improper, apparently satisfied SEC guidelines. Explains Robert Gabele, president of Invest/Net, a Fort Lauderdale research firm that tracks insider trades: "Many corporate insider trades are not illegal, just unethical. There's a thin gray line."

Discerning that line can be difficult. For instance, were Household International executives Michael DeLuca and Donald Lohmann just lucky when they elected to unload about three-quarters of their holdings at between 53 and 55 a share only days before the big Chicago-area financial concern revealed problem loans? Household's stock sank 11 points in the aftermath of the March 26 announcement. Neither executive is accused of wrongdoing.

Then there's the case of Browning-Ferris. Last August two top executives at the Houston waste-disposal concern sold more than $2 million worth of company stock. General counsel Howard Hoover and chief financial officer R. John Stanton Jr. dumped half of their holdings at about 27 a share. The trades attracted little attention or suspicion until Browning-Ferris surprised Wall Street with a gloomier-than-expected earnings forecast and its stock plunged 19%. While most shareholders got trashed, Stanton and Hoover avoided $468,000 in losses with their timely sales. Disclosure of the trades led to the resignation of both executives as well as an SEC investigation, which is ongoing.

But it is outside investors, rather than regulators, who are applying the most pressure on corporate insiders. Increasingly, shareholders are turning to the courts. There are nearly 100 investor lawsuits pending against insiders, says James Newman, publisher of the Securities Class Action Alert newsletter, double the number of five years ago. Shareholders at Compaq Computer, for example, sued last year after insiders unloaded $16 million in stock just weeks before the company's stunning revelation of an inventory glut and exchange-rate problems. Compaq's stock dropped 27% on the news.

Stung by criticism of lax enforcement, the SEC has been pressured into cracking down. The watchdog agency has opened a raft of investigations into cases involving corporate insiders in recent months. In one of its toughest actions to date, the SEC last October filed insider-trading charges against three top officers at Shared Medical Systems. The executives, including CEO R. James Macaleer, are accused of making false statements about Shared Medical's financial health and then selling 157,400 shares, at 35 to 4114 each, before the Malvern, Pa., company disclosed a sudden sharp decline in its earnings. The news sent the stock tumbling to 27. The agency is seeking $1.7 million in "unlawfully avoided losses," plus a civil penalty of three times that amount.

While corporate insiders have rarely faced criminal charges a la Michael Milken and Ivan Boesky, observers expect that to change. Says Robert Lamb, professor of finance at New York University: "We may soon see corporate executives being carried away in handcuffs."

For now, though, the SEC is coming down the hardest on insiders who fail to file timely forms disclosing their trades and holdings. The regulatory agency won authority last year to impose fines of up to $50,000 for late or omitted filings. It also expanded the definition of insider. In the past, officers from vice presidents to CEOs were required to file. But now the category is defined by job function rather than by company title. Typically, executives with major responsibilities, including lab directors, actuaries and software developers, must file.

To improve surveillance, the SEC is beginning to use computer data bases to keep track of the nearly 200,000 insider filings that the agency receives each year. The changes have already boosted compliance. The number of insider reports filed after deadline has declined from 55% five years ago to less than 10%.

Many critics, however, complain that the SEC's regulatory bark is worse than its bite. They point to a case, decided last month, involving Neil Rogen, founder and former chairman of Memory Metals, who without admitting or denying guilt agreed to a court order to settle insider-trading charges with forfeited profits and fines totaling $6 million. The SEC, though, waived the fines when Rogen said he didn't have the money to pay them.

Some critics point out that one SEC decision may even make it more profitable for insiders to act on privileged information. Under pressure from probusiness lobbyists in Congress, the SEC last year removed a 57-year-old regulation that required corporate insiders who exercised options to wait at least six months before selling the stock. The rule, which accounted for the vast majority of violations by corporate insiders, served partly to reduce the potential payoff for improper trades. Now when insiders decide to unload their portfolios, they can get a bigger bang for the buck by exercising their options and immediately selling the stock. The change in the law, according to some securities experts, was a sop to Big Business. Says Levy: "The SEC has wiped an entire class of violations off the books. It didn't stop the abuses; it just pretends they don't exist." Insiders are already cashing in. During the first three months of this year, insiders exercised $1 billion worth of options, in contrast to $214 million in the same period last year.

Still, it can pay to follow the insiders. Important clues about a company's outlook can be gleaned by monitoring insider transactions. Sometimes trades can be misleading, since some firms allow insiders to buy or sell shares only during specific periods, such as after quarterly earnings announcements. Investors should be suspicious if insiders are selling near yearly lows, when buying is expected. It may be time to unload the stock. Similarly, if they are buying rather than selling at high points, that can be interpreted as a good sign. More revealing, though, is the number of insiders involved. Says Invest/ Net's Gabele: "I'd rather find seven vice presidents buying 1,000 shares each than the president buying 5,000 shares. The more insiders are acting in concert, the stronger the consensus."

But a note of caution is due. Insiders can blow it. Anticipating a favorable business climate, six corporate officers at Southwest Gas last year loaded up on the company's stock at prices averaging 15. The stock climbed as high as 18, but then the company was jolted by a succession of negative developments. A ruling by the Office of Thrift Supervision forced Southwest to set aside $17 million to cover bad loans in its savings-bank division. And the company's request for a $43 million rate hike was put off by the Arizona public-service commission. Southwest's stock hit the skids, sliding as low as 8 by August. It just goes to show that, even for insiders, playing the market is not a science.